JOSEPH GIGLIO: Time to make overt corporate tax inversions

Friday

Aug 1, 2014 at 5:00 AMAug 5, 2014 at 11:18 AM

Every political season brings new issues and controversies. One of the big ones this time around is “corporate tax inversions.” Unfortunately, the trend is a symptom of a bigger problem that will require the kind of long-term solution that is rarely crafted in even-numbered years.

In business terms, inversion is the restructuring of a U.S. company’s corporate form such that it becomes a foreign corporation based in a country with low corporate taxes, basically turning the corporate structure on its head. American multinational corporations undertake these transactions because the top U.S. corporate tax rate of 35 percent is higher than in many other countries and the U.S. taxes worldwide income at a time when foreign income is increasing substantially.

One example is Medtronic Inc.’s recent agreement to buy Covidien for $43 billion. The move enables Medtronic to domicile to Ireland, take advantage of low corporate tax rates and access its overseas cash without having to pay high repatriation costs.

These inversion deals allow American corporations to reduce their average combined federal and state corporate tax rate of 40 percent. This rate is one of the world’s highest, double the European average more than triple the 12.5 percent rate in Ireland. Over the past 25 years, almost all countries in the Organization for Economic Cooperation and Development except the U.S. have lowered their top corporate tax rate.

The increased number of American firms that have incorporated abroad to reduce their tax burden has prompted a series of congressional hearings, where representatives can express their frustration and anger at maximum strength about firms reducing the U.S. corporate income tax base. The Joint Committee on Taxation estimates that future deals will cost the U.S. almost $20 billion in corporate tax revenue over the next 10 years.

The flurry of inversion deals has also angered President Obama, who has said the practice is “wrong” and urged Congress to close the loophole.

High corporate tax rates are not the only problem. What is frequently overlooked in these contentious discussions is that the United States, unlike many other countries, employs a worldwide taxation system, taxing corporate foreign income at the same rate as domestic income while permitting corporations to claim limited tax credits for income taxes paid to foreign governments to mitigate the possibility of double taxation. The worldwide system is problematic in a time when foreign markets account for an ever-larger portion of American corporate profits.

Determining corporate taxable foreign income and the credits that can be applied against associated tax liabilities is complicated and forbidding. For example, American firms have discretion as to how they allocate costs among subsidiaries. By allocating more costs to domestic operations, they reduce domestic profits and increase foreign profits.

The current arrangement creates an incentive for American firms to reinvest this foreign income overseas rather than repatriating in the form of dividends. Business groups and their congressional allies want the U.S. to adopt the practice used in many other countries and tax income based on where it is generated.

Joseph M. Giglio is a professor of strategic management at Northeastern University's D'Amore-McKim School of Business.
By anyone’s standards the U.S. has a very complex tax code. Corporate tax reforms must recognize global economic changes and resolve the fundamental contradictions in the current corporate income tax structure. That means adjusting to the reality of declining tax rates in other countries and the increased importance of foreign markets.

All this strongly suggests that truly solving the problems created by the current corporate tax regime requires a long-term fix and cannot be solved unilaterally by the U.S. Some second-order benefits may be gained by plugging specific loopholes, but a real long-term solution requires better international coordination of tax rules to minimize tax avoidance activities by multinational corporations.

Not too long ago, a corporation could be successful by focusing on making and selling goods and services within its national boundaries. Profits earned from exporting products were considered frosting on the cake but not really essential to corporate success. That is no longer the case, and the U.S. needs to reform its corporate tax code to reflect this new reality.